McKinsey on being top quartile

To stay ahead, GPs must refine their proposition, focus on what they do best and tweak their incentives.

We recently wrote about new research that suggests private equity returns are much higher than previously supposed. Those findings should kick-start a new wave of growth. The good news comes with an asterisk, however: the evidence also suggests that top-quartile firms have a great deal of difficulty replicating their performance from fund to fund. Success in private equity is becoming more democratic.

To make the most of a fast-growing, more competitive era, general partners can consider several steps. First, limited partners are looking for clear, differentiated strategies, with relevant and proven capabilities; GPs will need ready answers. As in the past, they must be able to point to a track record of success – ideally one that does not depend on clever accounting – but also be able to say how that track record was achieved and, even more critically, how it will be maintained. Firms will need to be able to describe the fundamental underpinnings of their outperformance – in particular, the skills, brand, focus, and other capabilities that the firm brings to its deals. They may also need to explain how these capabilities are evolving to allow them to keep ahead in a competitive market. 

As a simple example of the kind of distinctive skill and insight that LPs may now seek, McKinsey research has shown that deal partners with strong transaction backgrounds add considerable value to transactions in roll-ups – but not as much when companies develop organically. The converse is true for those with managerial or consulting backgrounds. 

Knowing how a firm generates performance can help a GP articulate a differentiated value proposition and strategy for the future, one that sets it apart from both its private equity competitors and from LPs that aspire to invest directly. Firms may want to review the possibilities for increasing their specialisation, by sector, geography, or deal type. The GP can then raise funds for investments that can only succeed with those specialised skills. Imagine a firm with exceptional abilities in chemical deal-making and operations. It might raise a fund with a 15-year lifetime, rather than the usual 10 years, to ensure that it was active through at least two of the industry’s cycles. And it might swear off any investment that is not directly tied to the sub-sectors in which it specialises.

As LPs concentrate their investments with fewer firms, GPs should consider ways to integrate investors further into their business system. Co-investing is already well established; other moves can deepen the relationship. For example, GPs might provide investment advice to LPs on some portions of their portfolio that are not invested in private equity. A GP with expertise in China, for example, might counsel an LP on how to invest there. And GPs might look to LPs as an exit route for certain types of businesses that LPs might want to own for the long term. All these closer relationships can benefit both parties.

Finally, GPs can consider some bold changes to their incentive structures.  In an era of smaller fund sizes, the 2 percent management fee was designed to 'keep the lights on'. Today, even though most firms have lowered the fee, some investors worry that it distracts managers from their main task of generating returns. Firms have an opportunity to distinguish themselves by shifting incentives away from the management fee and towards carried interest. This is not a zero-sum move; rather, it should increase the size of the profit pool that GPs and their investors share.

Along these same lines, firms can experiment with '1 and 20', '2 and 15', and other hybrid structures for carried interest. Firms might also consider measuring carry by its true alpha, rather than returns in excess of an absolute threshold. Both steps would better align the interests of GPs and their investors.

Gary Pinkus is a director in McKinsey & Company's San Francisco office. McKinsey partners Sacha Ghai, Conor Kehoe and Bryce Klempner also contributed to this article.